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International Accounting, 6/e. Frederick D.S. Choi Gary K. Meek. Chapter 6: Foreign Currency Translation. Learning Objectives . Why do firms translate from one currency to another? What is the difference between a spot, forward, and swap transaction?
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International Accounting, 6/e Frederick D.S. Choi Gary K. Meek Chapter 6: Foreign Currency Translation
Learning Objectives • Why do firms translate from one currency to another? • What is the difference between a spot, forward, and swap transaction? • What exchange rates are used in the currency translation process and what are their financial statement effects? • How does a translation gain or loss differ from a transactions gain or loss? • Is there more than one way of translating financial statements from one currency to another? If so, what are they? • How does the temporal method of currency translation differ from the current rate method? • What is the relationship between currency translation and inflation?
Why do Firms Translate? • Facilitates the preparation of consolidated financial statements that allow readers to see the performance of a multinational company’s total operations both domestic and foreign. • Facilitates the measurement of a firm’s exposure to foreign exchange risk. • Facilitates the recording of foreign currency transactions; i.e., foreign currency sales, purchases, borrowing or lending in the consolidated entity’s reporting currency. • Facilitates reporting domestic accounts to foreign audiences-of-interest.
Types of Transaction Rates • Spot transactions: the physical exchange of one currency for another in which delivery takes place immediately. • Direct quote: the exchange rate specifies the number of domestic currency units needed to acquire a unit of foreign currency. • Indirect quote: the exchange rate specifies the price of a unit of the domestic currency in terms of the foreign currency. • Forward transaction: agreements to exchange a specified amount of one currency for another at a future date. • Swap transaction: involves the simultaneous spot purchase and forward sale, or spot sale and forward purchase of a currency.
Accounting for Spot Transactions • Spot transaction: occurs when an enterprise purchases or sells goods for which payment is made in a foreign currency, or when it borrows or lends foreign currency. • At the transaction date, each asset, liability, revenue, and expense denominated in a foreign currency is measured and recorded in the functional currency of the reporting entity at the spot exchange rate in effect on that date. • Functional currency is the primary currency in which the reporting entity transacts business and generates and spends cash; e.g., dollars in the case of a U.S. reporting entity. • At each balance sheet date, recorded balances denominated in a currency other than the functional currency of the reporting entity is adjusted to reflect the current exchange rate.
Accounting for Spot Transactions (contin) • A foreign exchange gain or loss is recorded whenever the exchange rate changes between the original transaction date and the settlement date, or between the original transaction date and the financial statement date should financial statements be prepared prior to settlement. • Example: On September 1, a calendar year U.S. manufacturer sells, on 90-day credit, goods to a Swedish importer for SEK 1,000,000. The dollar/krona exchange rate is $0.14 = SEK1 on September 1, $0.13 = SEK 1 on September 30, and $0.11 = SEK 1 on December 1.
Types of Translation Rates and their Statement Effects • Historical rate: the exchange rate prevailing when a foreign currency asset was first acquired or a foreign currency liability first incurred. • Preserves the original cost equivalent of a foreign currency item in the reporting currency. • Use of historical rates do not give rise to translation gains or losses, which are increases or decreases in the reporting currency equivalent of the foreign currency. • Current rate: the exchange rate prevailing as of the financial statement date. • Changes the reporting currency equivalent of a foreign currency item whenever exchange rates change. • Use of the current rate gives rise to translation gains and losses. • Average rate: a simple or weighted average of either historical or current exchange rates.
Translation vs. Transaction Gains or Losses • Translation gains or losses: result from a restatement process. • Transactions gains or losses: result from the physical exchange of one currency for another. • Gain or loss on a settled transaction: arises whenever the exchange rate used to book the original transaction differs from the exchange rate used at settlement. • Gain or loss on an unsettled transaction: arises whenever consolidated financial statements are prepared before settlement and the current rate has changed since the transaction date. • Is similar to a translation gain or loss as it results from a restatement process.
Types of Translation Methods • Single rate method: applies a single exchange rate, the current rate, to all foreign currency assets and liabilities. • Multiple rate methods: Use some combination or current and historical rates to translate foreign currency balances.
Current-Noncurrent Method • Current assets and current liabilities translated at the current rate. • Noncurrent assets and liabilities translated at the historical rate. • Revenues and expenses (excluding depreciation and amortization) translated at average rates. • Depreciation and amortization charges at historical rates in effect when related assets are acquired.
Monetary-Nonmonetary Method • Monetary assets and liabilities translated at current rates. • Nonmonetary assets and liabilities translated at historical rates. • Revenues and expenses, excluding depreciation, amortization and cost of sales, at average rates. • Depreciation, amortization charges, and cost of sales at historical rates in effect when related assets are acquired. • See Exhibits 6-8 and 6-9.
Temporal Method • Monetary assets and liabilities translated at the current rate. • Nonmonetary items translated at rates that preserve their original measurement bases. • Foreign currency balances at historical cost are translated at historical rates. • Foreign currency balances at current cost or market value are translated at the current rate. • Revenues and expenses, including cost of sales if inventories are carried at market, at average rates. • Depreciation, amortization charges, and cost of sales when inventories are carried at cost, at historical rates in effect when related assets are acquired. • See Exhibits 6-8 and 6-9.
Current (Single) Rate Method • All foreign assets and liabilities translated at the current rate. • All revenues and expenses are translated by an appropriately weighted average of current exchange rates for the period. • See Exhibits 6-8 and 6-9.
Features of FASB 52 and IAS 21 • Objectives • Reflect in consolidated statements the financial results and relationships measured in the primary currency in which each consolidated entity does business. • Provide information compatible with the expected economic effects of an exchange rate change on an entity’s cash flows and equity. • Objectives based on the notion of a functional currency defined earlier. • Functional currency can be the parent currency. • Functional currency can be the local currency.
Features of FASB 52 and IAS 21 (contin) • Translation when the parent currency is functional. • Foreign currency financial statements remeasured to reporting currency using the temporal method. • Translation gains and losses resulting from the translation process are included in current income. • Translation when the local currency is functional. • Foreign currency financial statements translated to reporting currency using the current rate method. • Translation gains and losses disclosed as a separate component of consolidated equity.
Relationship Between Foreign Currency Translation and Inflation • The external value of a country’s currency is inversely related to its rate of inflation. • IAS 21 permits restatement for local inflation prior to currency translation. • FAS 52 requires use of the parent currency as the functional currency for foreign operations located in hyperinflationary environments (i.e., countries where the cumulative rate of inflation exceeds 100% over a three-year period).
